The Budget's Misguided Parsimony

February 13, 2005

By Michael Mandel Today I'm going to tell you about the most important economic statistic you've never heard of. It's more significant than the trade deficit, more far-reaching than the budget gap, and even a bigger deal than the unemployment rate.

The statistic is multifactor productivity (MFP), and it comes out every year or so in a Bureau of Labor Statistics report called, quite naturally, "Multifactor Productivity Trends." The latest report, which showed that MFP rose by 2% in 2002, was released on Feb. 1 and received virtually no coverage in the press.

The biggest increase since 1992, this gain is the main reason the U.S. economy has continued to prosper despite the big budget and trade deficits. The lack of attention is especially unfortunate given the upcoming debates over the Bush Administration's budget proposal for 2006, which cuts funding for education as well as nondefense research and development -- two of the key factors driving MFP.

FREE MONEY. Of course, right now you're asking: What the heck is multifactor productivity, and why is it so important? MFP is the lesser-known cousin of labor productivity, which is the amount of output that an average worker can produce in an hour. So, for example, if you're digging ditches, your labor productivity is the number of feet of ditches you can dig in an hour.

A rise in labor productivity can happen for a lot of different reasons. Workers can have more and better machinery and equipment to use -- say, a backhoe rather than a shovel, to move dirt. Or the workers can become better trained in using the equipment they already have. In either case, the increase in labor productivity carries a cost: the price of the backhoe or the expense of training the worker.

Multifactor productivity measures something different. When MFP rises, it means output per hour of the average worker goes up without any additional skills or education or a change in equipment. An increase in MFP equals free money, extra production that you don't have pay for.

MEASURE OF STRENGTH. Multifactor productivity is borne of the essence of technological innovation -- the creation of new products and new opportunities out of ideas and thin air. For example, the spread of the Internet has not only made doing business easier and cheaper but also allowed people to do things that weren't even possible in the past. Think about Amazon (AMZN), Google (GOOG), and eBay (EBAY). Wireless phones aren't just a substitute for landlines; they enable people to organize their activities in very different ways.

The rate of multifactor productivity growth represents the single best indicator of the economy's true strength. When MFP is increasing rapidly, the size of the economic pie expands, real wages rise, profits go up, and everyone feels good. When that figure stagnates, things are tough all around.

For example, multifactor productivity didn't rise at all in 1973-83, a period that included the era of runaway inflation, President Jimmy Carter's famous "malaise" speech, and the deepest recession since the Great Depression. During that stretch, the stock market, adjusted for inflation, fell by 34%, while real hourly wages for production and nonsupervisory workers descended by 11%.

NECESSARY FUNDING. By contrast, the birth of the New Economy can be clearly seen in the sharp acceleration of multifactor productivity growth starting in 1996. From that point to 2002 (the latest year for which figures are available), MFP gained a bit more than 1% a year. From 1995 to today, real wages have risen by 9%, while the inflation-adjusted stock market is up by 68%.

An economy with rapid multifactor productivity growth is potentially quite profitable for investors, which helps explain why the U.S. can attract so much foreign capital to fund its trade deficit. High MFP also generates lots of extra output, useful for paying for, say, military actions or better health-care benefits. It's like having a cushion or a security blanket.

So what does this have to do with the budget debate now starting up in Washington? Higher multifactor productivity comes mainly via technological progress. And that requires the willingness to spend on R&D and education.

HARMFUL CUTBACKS. Unfortunately, in an attempt to cut the budget deficit, the Bush Administration has held down government spending on R&D and education. The budget proposal calls for federal nondefense R&D spending for fiscal year 2006 to fall by 1% compared to the previous year, after inflation, while real outlays on education and training are proposed to drop by 6%.

This misguided parsimony can only hurt the nation's ability to maintain a rapid pace of multifactor productivity growth. Putting more resources into technology and education is the best way to ensure that the bounty of higher MFP continues in the future. Mandel is chief economist for BusinessWeek